Compound Interest - Every Saver's Dream

The beauty of compound interest is that, once it starts, it doesn't stop. You can turn pennies into 100's of dollars through this natural phenomenon.

Many of us have heard of compound interest, and some of us have actually seen it in action. Do you know how it really works? This article explores the marvel of compound interest in detail. Very simply, compound interest is the interest you earn on the interest you earned previously! Still not sure? Let's review some of the principles of compound interest and look at some examples.

Annual Percentage Yield (APY)

When you deposit money into a bank account or other investment product, you expect to earn interest or generate a return on that investment. The rate of return you receive will depend on many variables. For example, the rate of return on a savings account may be stated as 4%, and a long-term certificate of deposit may offer a stated rate of return of 8%. When these rates are converted into an annual percentage yield (APY), you will find that the APY, or effective interest rate, is several basis points higher than the stated rate (a basis point is one hundredth of a percent). This is because of compound interest. Since you are earning interest on your interest, your overall yield is actually increased.

The Value of Time

The most important element of compound interest is time. The longer your investment sits, the longer the interest earns interest. Let's look at an example. Let's say you save $80 a month and you've got it invested in a money market account that earns an average of 7% annually. What is the effect of time on this investment?

Number of Years Elapsed

Value of $80 monthly savings at 7%

5

$6,388

10

$15,914

20

$51,310

25

$82,910

30

$130,037

Just imagine if you doubled your investment or improved your rate of return.

Methods of Compounding

When choosing a savings product, make sure you understand how the interest is compounded - it could be daily, monthly, quarterly, or even yearly. The more frequently your interest is compounded, the higher your overall yield, or annual percentage yield (APY), will be. You can evaluate different savings products by simply comparing the APY. The annual percentage yield is determined and quoted by the financial institution by taking the variable terms, such as rate and interest calculation method, and converting them into an annual net yield rate. For example, a Certificate of Deposit that is stated to earn 5% compounded monthly will actually generate an APY of 5.12%, while a Certificate of Deposit that is stated to earn 5% simple interest will only earn 5%. For more information about interest calculation, see the Federal Reserve Bank of Chicago's article, ABCs of Figuring Interest.

Compare Simple Interest

If your investment choice doesn't compound interest, then it pays simple interest. This means interest is only computed on your original principal sum invested. Depending upon how often the interest is compounded and the rate of return, sometimes, a simple-interest investment product can be just as lucrative as a compounding product. Make sure you compare carefully and make your decision on the best rate of return you can find. For a more detailed discussion of simple and compound interest, see the Ask Dr. Math Interest Calculations article.

Perhaps the biggest risk of investing is not investing at all. Before you are ready to enter the market, you must first define the type of investor you are by looking at your goals and the risks you are willing to take to achieve them.